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27-1 The Foreign Exchange Market

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T

he last chapter grappled with risks from changing interest
rates and volatile commodity prices. Corporations that
operate internationally face still more hazards from currency
fluctuations and political risks.
To understand currency risk, you first have to understand
how the foreign exchange market works and how currency
exchange rates are determined. We cover those topics first,
with special emphasis on the linkages between exchange
rates and cross-country differences in interest rates and infla-
tion. Then we describe how corporations assess and hedge
their currency exposures.
We also review international capital investment decisions.
Cash flows for an investment project in Germany, say, must
be forecasted in euros, with attention to German inflation

rates and taxes. But euro cash flows require a euro discount

rate. How should that rate be estimated? Should it depend on

whether the investing company is located in the United States,

Germany, or another country? Should the discount rate be

adjusted for the risk that the euro may fall relative to other cur-

rencies? (The answer to the last question is no. The answers

to the preceding questions are not so clear-cut.)

We conclude the chapter with a discussion of political risk.

Political risk means possible adverse acts by a hostile foreign

government, for example, discriminatory taxes or limits on

the profits that can be taken out of the country. Sometimes

governments expropriate businesses with minimal compen-

sation. We explain how companies structure their operations

and financing to reduce their exposure to political risks.

Managing International Risks

An American company that imports goods from France may need to buy euros to pay for the

purchase. An American company exporting to France may receive euros, which it sells in

exchange for dollars. Both firms make use of the foreign exchange market.

The foreign exchange market has no central marketplace. Business is conducted electronically.

The principal dealers are the larger commercial banks and investment banks. A corporation that

wants to buy or sell currency usually does so through a commercial bank. Turnover in the foreign

exchange market is huge. In London in April 2013, $2,726 billion of currency changed hands each

day. That is equivalent to an annual turnover of about $995 trillion ($995,000,000,000,000).

New York, Singapore, and Tokyo together accounted for a further $2,259 billion of turnover per day.^1

Table 27.1 shows a sample of exchange rates in November 2014. Exchange rates are gen-

erally expressed in terms of the number of units of the foreign currency needed to buy one

U.S. dollar (USD). This is termed an indirect quote. In the first column of Table  27.1, the

(^1) The results of the triennial survey of foreign exchange business are published on http://www.bis.org/forum/research.htm.
Part 8 Risk Management

27

CHAPTER